RSP Permian: One of the Most Compelling Upstream Energy Opportunities

The deal, which closes in stages between the fourth quarter this year and the first quarter in 2017, adds 41,000 net acres in the Delaware Basin, pushing RSP's total Permian holding over 100,000 net acres. It will also provide roughly 15,000 barrels of oil equivalent per day of oil-weighted production and augment the firm's drilling inventory with 3,200 gross incremental locations (many of which are expected to yield recoveries of 1 million boe or better, though until we get more concrete data to verify, this asset is heavily risked in our model).

The total consideration includes $1.2 billion cash and 30 million newly issued shares. Further, to minimize the impact on the firm's balance sheet, management opted to pair this transaction with an equity offering that is expected to raise $950 million in proceeds. Consequently, while RSP's financial leverage is a tad higher than the peer average, we expect this to improve very quickly, and net debt/EBITDA should fall below 2 times by the end of 2017.

Additionally, the firm announced third-quarter average production of 29.8 mboe/d (73% oil), which was a hair above our estimate. Guidance for the full year was raised to 29 mboe/d at the midpoint from 27.5 mboe/d. Though the first portion of the deal closes during the fourth quarter, the period of ownership isn't long enough to affect the 2016 average much. Instead, management highlighted that it now expects to complete 54-58 horizontal wells in 2016, two more than previously announced. Preliminary guidance for 2017 calls for 54 mboe/d, with a budget of $600 million.

RSP Permian is one of the smaller operators in our upstream coverage, with over 100,000 net acres in the Permian Basin. Two thirds of that total is situated on the Midland side, and is ideally located in the core of the play. The company’s "focus area" extends across Martin, Midland, and Glasscock counties. Stacked pay in the region means the ultimate resource potential is a moving target, and RSP is concentrating on the most productive Wolfcamp and Lower Spraberry reservoir intervals in its Midland Basin inventory for now. The remaining layers have yet to be fully delineated but could drive substantial upside in a stronger commodity price environment. Meanwhile, the firm is getting ready to integrate its recently purchased Delaware Basin property. We believe the acquired acreage is at least as profitable as RSP's pre-existing property, but until the firm announces drilling results there this portion of the portfolio is more speculative.

The firm's track record in the Midland Basin has been impressive and consistent. Its production has a high oil content, supporting very robust drilling economics across the firm's entire position (with some truly spectacular results in standout areas like Calverley and Woody). Management has also shaved off more than 40% from its well costs since the 2014 peak in crude prices, despite adopting enhanced completion methods that cost more but drive stronger overall returns. Consequently, the firm is better positioned than most peers to cope with low oil prices and has the ability to grow its production without adding leverage even if prices average only $40 per barrel in 2017.

The firm's balance sheet is tighter than we'd prefer but still in line with the peer average, since most firms have seen spiraling leverage due to the recent collapse in crude prices. Crucially, RSP Permian has the ability to fund its operations entirely with cash flows from operations, even if prices deteriorate. And if our current forecasts for crude prices are correct, the firm will be able to deleverage fairly quickly--we believe net debt/trailing EBITDA will fall below 2 times before the end of 2017.

Moats are established by firms with durable competitive advantages that enable them to earn sustainable excess returns on capital. They are not cyclical, and severe commodity price headwinds do not preclude best-in-class operators from earning moat ratings if they can still generate significant value in the long run. The competitive advantage of exploration and production firms largely stems from the quality of their acreage. Long-run oil and gas prices are set by the marginal cost of extraction, so the ability to earn excess returns depends on the position of each firm’s assets on the appropriate cost curve, as well as the ultimate price received for the firm's production (realized selling prices can deviate from benchmarks for several reasons). Significant future resource potential is also a vital component of our moat framework because firms with limited low-cost drilling opportunities will be unable to supplant declining production without eroding their profitability.

RSP Permian's core position is situated ideally in the heart of the Midland Basin (which is one of the lowest-cost oil plays in North America). Management's published type curves are consistent with internal rates of return on new wells in core reservoir intervals, including the Wolfcamp A and B and the Upper and Middle Spraberry, of at least 25%. However, recent well performance indicates that these type curves are overly pessimistic. Actual returns could be as high as 40%-60% if our commodity price forecasts are correct.

The wells in these four highly productive zones break even as long as West Texas Intermediate crude exceeds $32 per barrel, and the firm has enough drilling locations in its inventory to support more than two decades of activity at the current pace (although substantial acceleration is likely). The rest of the Midland Basin portfolio is more speculative and is unlikely to drive the same stellar returns as these four zones can, but could still drive significant upside.

The true potential of the recently acquired Delaware Basin acreage remains to be seen, but we believe this part of the portfolio will be at least as profitable as the firm's core position in the Midland Basin. However, though we believe the compelling field-level economics of RSP's assets can eventually support sustainable excess returns on capital, it could take several years to get there. Accordingly, we do not award a narrow-moat rating.

As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure this firm’s profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy.